401k Withdrawal for Home Purchase

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What is a 401(k)?

A 401(k) is a company-sponsored retirement account. It is called your 401(k) because the foundation for this savings plan is the 401K provision in the IRS code. Employees contribute part of their salaries, and some employers can match it. Instead of getting a constant interest rate, you must invest your 401(k) savings into securities (stocks, bonds, ETFs, REITs, etc.) to earn a return. 401(k) accounts have three main benefits to encourage people to make contributions.

1. Any income contributed to a 401(k) is not taxed.
2. Any returns generated on investments from your 401(k) are not taxed.
3. Employers may match contributions either partially or fully.

However, these benefits do not exist without caveats. The government does not want your 401(k) to be used before a certain age, so the government puts certain restrictions and penalties on early withdrawals to encourage long-term investing for retirement. These penalties include the 10% withdrawal fee for an early withdrawal. In addition to the fee, the withdrawn amount is subject to income tax. The following table can help you understand whether you can withdraw money without any penalty.

As an example of an early withdrawal penalty, suppose you need to withdraw $50,000 to cover the down payment. Because of the 10% penalty, the 401(k) balance will decrease by $55,000. Additionally, the $50,000 that has been withdrawn will be subject to income tax, so the owner of the account will have to also pay income taxes on these $50,000.

Some homebuyers who cannot put a full 20% down payment are also offered an option to put less than 20% and take private mortgage insurance (PMI) instead. Since private mortgage insurance is paid by the borrower and protects the lender, many borrowers believe that they should avoid it at all costs. That is when they may think that it is better to withdraw money from their 401(k) instead of facing higher payments on the mortgage.

Even though sometimes it might be less costly to withdraw money from a 401(k), in many cases, it might be better to use PMI. PMI usually has an annual premium of around 0.5% to 1.5% of the principal amount. Additionally, the 401(k) tends to grow at a certain rate that depends on the investment portfolio in the account. An average growth rate of a market portfolio grows by 7% annually. Withdrawing the amount from 401(k) may lower the mortgage payments by around 1%, but you also do not earn interest of around 7% on the money withdrawn in addition to the 10% withdrawal penalty.

Buying a House With 401K

The minimum down payment required for a loan is the largest obstacle to buying a home. Even if you know your income is more than enough to support your mortgage payments, you may not have enough saved to cover the down payment that some mortgages require. Many people look at their assets and think taking money out of their 401(k) is a quick and easy method of meeting this requirement. However, there are many conditions and costs associated with 401(k) withdrawal. It is suggested to avoid withdrawing money from 401(k) if it is not necessary.

While the government discourages early withdrawals from your 401k, you can access the money in it using two different methods. You may either take out a 401(k) loan or make a 401(k) “hardship” withdrawal.

How Much Money Can You Take From 401(K)?

1. 401(k) Loans

A 401(k) loan is a “self-issued” loan, which means you borrow from your own 401(k) and repayments return to your account. Typically, the maximum loan term is five years, but this can be extended if the loan is used to buy a principal residence. With a 401(k) loan, you avoid the 10% early withdrawal penalty, and the amount will not be subject to income tax. The government does this because you have to repay yourself, so you are still saving for your retirement.

2. 401(k) "Hardship" Withdrawal

If your employer does not offer 401(k) loans, they may still offer a 401(k) withdrawal. For people under the age of 59½, a “hardship” withdrawal or early withdrawal from your 401(k) is allowed under special circumstances, which are on the IRS Hardship Distributions page. Using your 410(k) for a down payment on a principal residence is classified as a hardship withdrawal. By opting to use a hardship withdrawal, you will have to pay the 10% early withdrawal penalty, and this amount will be considered taxable income. Exceptions are on the official IRS page. Generally, these exceptions are difficult to qualify for, so a 401(k) loan is usually better.

Alternatives to 401(k) for a Home Purchase

Using 401(k) to buy a house before you are 59.5 years old may be very expensive considering the penalties and taxes that need to be paid for early withdrawal. Luckily, there are other ways a buyer can raise the funds for the house.

Before proceeding to collect money from different sources, check if your mortgage lender allows you to make a down payment of less than 20%. You are only required to make the minimum down payment, so if a lender is willing to issue a loan with a lower down payment, then you may be able to buy a house without raising additional funds. If your down payment is less than 20%, you get charged monthly Private Mortgage Insurance premiums until you own 20% of your home’s equity. Generally, paying for these premiums is better than taking money from your 401(k).

Before using your retirement funds to pay for a down payment, consider any alternatives you have available:

Savings and Investment Accounts

One of the easiest ways to raise money to buy a property is to check whether you have any liquid assets such as cash or short-term investments. Checking savings and investment accounts may be a good way to see whether you have enough funds to cover the costs of a home purchase. Before getting a mortgage, make sure your income supports the monthly mortgage payments and that you have savings for emergencies. Check how much house I can afford calculator to help you determine your affordability.

Government First-Time Home Buyer Programs

The federal government has many first-time homebuyer programs with lower minimum down payments and payment assistance programs. You should also check with your state’s local housing authority because each state has unique first-time homebuyer programs. These government-backed mortgages include programs for first-time home buyers and programs that target specific demographics.

*Some loan types such as FHA and USDA can accept a DTI of more than 43% if a borrower has a compensating factor such as a high credit score or a high down payment.

The most popular first-time home buyers program is the FHA loan. This loan is backed by the Federal Housing Administration. They require a minimum down payment of 3.5% and a credit score of at least 580. It is possible to get approved for an FHA loan with a lower credit score, but it will require a down payment of at least 10%. FHA loans also require private mortgage insurance until the loan-to-value ratio is below 80%. Other increasingly popular mortgage programs available are Freddie Mac Home Possible program and the Mannie Mae HomeReady program. They all focus on providing mortgage loans for households who may not be able to afford a 20% down payment for the house they want to purchase.

Other programs focus on specific demographics who may need assistance in purchasing a house. VA loans allow eligible veterans and service members to get a mortgage loan with no down payment. It also features low-interest rates and flexible mortgage terms. A USDA loan is another type of loan that allows people to pay less for a down payment. The main requirement for this type of loan is that the house is located in a rural area. It also has to be used as a primary residence by the borrower, and the borrower has to earn a low to median income. To learn more about USDA loan requirements, visit our USDA eligibility calculator.

Gifts From Family and Friends

Lenders permit gifts to be used for a downpayment and closing costs. This means that if you do not have enough money to cover the down payment, you can ask your family and friends for help. Getting a family gift can help you secure a down payment without having to take on unnecessary debt or compromise your retirement funds. It is important to note that the funds from friends and family must be gifted. The funds cannot be loaned or given with the expectation of any kind of financial or physical return.

Personal Loans

Banks and other lenders will give you a personal loan if your creditworthiness is high. However, this will add to your Debt-to-Income (DTI) ratio, which may affect your mortgage conditions and eligibility. If you cannot get the money any other way, you may consider a piggyback loan that allows the borrower to get a partial loan for a down payment on top of the mortgage.

IRA Accounts

There are special provisions for first-time home buyers if you have an IRA. If you have not owned a primary residence in the past two years, you can withdraw up to $10,000 without incurring the 10% early withdrawal penalty (additional amounts have the 10% penalty). This amount will still be considered taxable income.

Frequently Asked Questions

How Much Can I Withdraw From 401k for a Home Purchase?

The maximum withdrawal amount varies depending on the method you use. Start with a 401(k) loan because it is a financially responsible choice. You can cover any remaining fees with a 401(k) withdrawal because of the 401(k)’s stricter loan requirements. Due to a recent congress ruling, if your employer allows it, you are allowed to withdraw both your employer’s 401(k) contributions and any investment earnings as well as your contributions.

Should I Use 401k for a Home Purchase?

Your 401(k) should be the last place you look for down payment assistance. The government encourages you to keep money in this account to save for your retirement. Even with a 401(k) loan, you cannot make contributions for five years. The money in a 401(k) appreciates through investment returns. If you withdrew $20,000 out of your account today, with an annualized return of just 5%, you would be $86,000 poorer 30 years from now. There are also many other downsides associated with using your 401(k) for a home purchase:

• Early withdrawal penalties and increased taxable income.
• Your 401(k) provider may charge you additional fees for early withdrawals or loans.
• Since you cannot make contributions, you will lose out on any company matching programs that could double your contributions.
• If you lose your job or quit, you will have to repay a 401(k) loan in full.

How Can I Avoid Paying Early Withdrawal Penalty?

401(k) is designed in a way that discourages the account holders from withdrawing the funds prematurely by setting a 10% fee on the withdrawals as well as levying an income tax on the withdrawn funds. These fees make it very expensive to withdraw money from a 401(k) account. Of course, there is a way to avoid withdrawal penalties, but they are available to people who are at least 59 and a half years of age. It may be impossible to avoid the prepayment penalty if you are younger than 59 and a half years old and you choose to withdraw cash from the account.

It might be possible to get the funds sitting in the account by loaning them to yourself. This is a valid way to get some cash, but it cannot be considered a withdrawal mainly because you will have to pay it back to your account. If you fail to pay back a portion of the loan, you will be given early withdrawal penalties as well as income tax on the outstanding balance.